Optimal policy tradable and bankable pollution permits: taking the market microstructure into account

This paper analyses how the way emission permits are traded -their market microstructure-impacts the optimal policy to be adopted by the environmental agency. The microstructure used is one of a quote driven market type, which characterizes many financial markets: market makers act as intermediaries for trading the permits by setting a ask price and a bid price. The possibility of permit banking is also introduced in our dynamic two-period model. We show that when the market makers and the agency do not know the technology of the producers with certainty, a positive spread may be set by market makers and that, under some conditions, banking increases the expected welfare given this market microstructure. If such a microstructure takes place or is organised on markets for pollution permits, we recommend to allow for banking (a) if the marginal willingness to pay for the environment increases much over time, (b) if the pollutant is rather a stock than a flow one, and/or (c) if the incomplete information faced by the intermediaries and by the agency is severe. In the first period, the environmental agency will then have to define and allocate a larger amount of permits than if banking is not allowed, but a lower or a same amount of permits in the second period.